Financial Statement Analysis Methods: Horizontal vs. Vertical Analysis Introduction Financial statement information is used by both external and internal users, including investors, creditors, managers, and executives. These users must analyze the information in order to make business decisions, so understanding financial statements is of great importance. Several methods of performing financial statement analysis exist. This article discusses two of these methods: horizontal analysis and vertical analysis. Horizontal Analysis Methods of financial statement analysis generally involve comparing certain information. The horizontal analysis compares specific items over a number of accounting periods. For example, accounts payable may be compared over a period of months within a fiscal year, or revenue may be compared over a period of several years. These comparisons are performed in one of two different ways. Absolute Dollars One method of performing a horizontal financial statement analysis compares the absolute dollar amounts of certain items over a period of time. For example, this method would compare the actual dollar amount of operating expenses over a period of several accounting periods. This method is valuable when trying to determine whether a company is conservative or excessive in spending on certain items. This method also aids in determining the effects of outside influences on the company, such as increasing gas prices or a reduction in the cost of materials. Percentage The other method of performing horizontal financial statement analysis compares the percentage difference in certain items over a period of time. The dollar amount of the change is converted to a percentage change. For example, a change in operating expenses from $1,000 in period one to $1,050 in period two would be reported as a 5% increase. This method is particularly useful when comparing small companies to large companies. (1050 – 1000)/1000 X 100 = 5% Vertical Analysis Qazi Ashfaq | Financial Statement Analysis 1 The vertical analysis compares each separate figure to one specific figure in the financial statement. The comparison is reported as a percentage. This method compares several items to one certain item in the same accounting period. Users often expand upon vertical analysis by comparing the analyses of several periods to one another. This can reveal trends that may be helpful in decision making. An explanation of Vertical analysis of the income statement and vertical analysis of the balance sheet follows. Income Statement Performing vertical analysis of the income statement involves comparing each income statement item to sales. Each item is then reported as a percentage of sales. For example, if sales equals $10,000 and operating expenses equals $1,000, then operating expenses would be reported as 10% of sales. 1000/10,000 X 100 = 10% Balance Sheet Performing vertical analysis of the balance sheet involves comparing each balance sheet item to total assets. Each item is then reported as a percentage of total assets. For example, if cash equals $5,000 and total assets equals $25,000, then cash would be reported as 20% of total assets. References Edmonds, C., Edmonds, T., Olds, P., & Schneider, N. (2006). "Fundamental Managerial Accounting Concepts." 3rd ed. New York: McGraw-Hill Irwin. Qazi Ashfaq | Financial Statement Analysis 2 Session 1: Vertical and Horizontal Analysis Technique Session Learning Outcomes Learners will understand and be appreciative on the use of the horizontal and vertical analysis technique while analyzing the financial statements information, its application and interpretation. Important Learning Terms • Financial analysis • Horizontal financial statements analysis • Vertical financial statements analysis • Cross sectional financial statement analysis Introduction Financial analysis: is a process which involves reclassification and summarization of information through the establishment of ratios and trends. Analysis of financial statement: Refers to the examination of the statements for the purpose of acquiring additional information regarding the activities of the business. The users of the financial information often find analysis desirable for the interpretation of the firm’s activities. Note: The financial statement to be used for the purpose of analysis should be the audited ones. The audited financial statements give the analyst the auditor’s statement as to whether the records represent a fair view of the company’s affairs. The Objectives of Financial Statement Analysis The overall objective of financial statement analysis is the examination of a firm’s financial position and returns in relation to risk. This must be done with a view to forecasting the firm’s future prospective. For the purpose of understanding, the following financial statements will be used. Qazi Ashfaq | Financial Statement Analysis 3 A: Horizontal Financial Statement Analysis This technique is also known as comparative analysis. It is conducted by setting consecutive balance sheet, income statement or statement of cash flow side-by-side and reviewing changes in individual categories on a year-to-year or multiyear basis. The most important item revealed by comparative financial statement analysis is trend. A comparison of statements over several years reveals direction, speed and extent of a trend(s). The horizontal financial statements analysis is done by restating amount of each item or group of items as a percentage. Qazi Ashfaq | Financial Statement Analysis 4 Such percentages are calculated by selecting a base year and assign a weight of 100 to the amount of each item in the base year statement. Thereafter, the amounts of similar items or groups of items in prior or subsequent financial statements are expressed as a percentage of the base year amount. The resulting figures are called index numbers or trend ratios. From the balance sheet statement in exhibit 1. The following indexed balance sheet can be established. As basis of Analysis, the analyst may seek variables which seem to improve or deteriorate and bring a challenge to the stakeholders in their various decisions. Example from the previous table one can ask the following questions? • Why is there an increase in the stock of the company? Has the company changed its inventory policy? • Why did taxation increase so tremendously? Were there any changes in taxation? Is it reflected by the increase in sales? Profit? Qazi Ashfaq | Financial Statement Analysis 5 • Why is there an increase in the fixed assets and at the same time decrease in the long-term debt? How were these assets financed? • And many more question which can be elaborated by the management or which can be used as the basis for discussions. Individual Assignment 1: From the Exhibit 1, prepare horizontal analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation. B: Vertical/Cross-Sectional/Common Size Analysis Techniques Vertical/Cross-sectional/Common size statements came from the problems in comparing the financial statements of firms that differ in size. • In the balance sheet, for example, the assets as well as the liabilities and equity are each expressed as a 100% and each item in these categories is expressed as a percentage of the respective totals. • In the common size income statement, turnover is expressed as 100% and every item in the income statement is expressed as a percentage of turnover (sales). Qazi Ashfaq | Financial Statement Analysis 6 From the vertical analysis above, an analyst can compare the percentage mark-up of asset items and how they have been financed. The strategies may include increase/decrease the holding of certain assets. The analyst may as well observe the trend of the increase in the assets and liabilities over several years. Example: It can be observed that there is an increase in the holding of the current assets of the company. The management can seek the reasons of why the holding of these assets is continuing increasing. Exercise 2: From the Exhibit 1, prepare vertical analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation. Qazi Ashfaq | Financial Statement Analysis 7 Financial Analysis revised Page 8 of 54 pages. Chapter: 17: Module 3.4: Sensitivity Analysis of ICT Invest Session 1: Building a Financial Analysis Model for ICT Session Learning Outcome The purpose of this session is to show how the different variables studied in this course and other courses can affect the analysis of a project. In actual undertakings of projects, there are micro and micro variables which affect overall project analysis. Introduction Sensitivity Analysis (SA) is the study of how the variation in the output of a model (numerical or otherwise) can be apportioned, qualitatively or quantitatively, to different sources of variation. Sensitivity Analysis (SA) aims to ascertain how the model depends upon the information fed into it, upon its structure and upon the framing assumptions made to build it. This information can be invaluable, as: • Different level of acceptance (by the decision-makers and stakeholders) may be attached to different types of uncertainty. • Different uncertainties impact differently on the reliability, the robustness and the efficiency of the model. Sensitivity analysis is also referred to as “what if analysis” Building Financial Analysis Model Several activities can be considered in building financial analysis model. In the building of the financial model the following have to be considered: 1. Conservative estimations of the revenues/benefits This is helpful to ensure that the viability of the proposed project is not easily threatened by unfavorable circumstances. The capital budgeting should be done in a such a way that it has a build in system for conservative estimations. The revenue figures should be justifiable given the capital expenditure proposals. 2. Safety Margin Cost figures A margin of safety for the cost items should be estimated. He margin can be between 10% -30%. For instance, in estimation of installation costs of a wireless telephone system, 10%-30% of the normal installation costs can be added. The management can decide on the percentages in the cost estimation of various items depending on the experience and other firm considerations. 3. Flexible Investment yardsticks Qazi Ashfaq | Financial Statement Analysis 8 Cutting point for the investments can be changed considerably to allow more room for seeing beyond the normal cut-off points. Example if the policy of a company is to accept the projects with payback period of less than three years, the use of a prolonged period can be assessed to determine the impact thereto. 4. Calculating the Overall risk index Some projects may call for the calculation of the overall risk index for various project components. These cutoff points may be based on sales, prices, operating cots, etc. The company may vary all the items by 62% favorable, given the risks index consideration. 5. Judgment on Three point estimation Telecommunication companies may judge their operations on three point estimation based on the hours of access as follows: o Business (peak) hours E.g. From 0800hrs – 1800hrs o Evening/Morning (off-peak) hours E.g. from 0600hrs – 0800 hrs and from 1800hrs – 2200hrs. o Night Hours E.g 2200hrs-0600hrs Various interconnection and charging rates are considered between three different times as indicated above. Reasons may be due to the fact that the use of bandwidth (which is paid even if not consumed) varies from the three time zones indicated above. Other considerations may be backed on the market responses and returns. The returns for this case may be classified as: • Most pessimistic • Most likely Qazi Ashfaq | Financial Statement Analysis 9 Session 2: Ratio Analysis Techniques Session Learning Outcome Learners will understand and be appreciative on the use of the time series analysis technique while analysing the financial statements information, its application and interpretation Important Learning Terms • Ratio • Types of Ratios • Liquidity Ratios • Asset management/Activity ratios • Financial Leverage/Gearing ratios • Profitability ratios • Market valuation ratios • Ratio limitations A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage. Ratio analysis: is essentially concerned with the calculation of relationships which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgement. Note: A ratio on its own has little or no meaning at all. Consider a current ratio of 2:1. This means that for every 1 monetary value of current liabilities there are 2 of assets. However each business is different and each has different working capital requirements. From this ratio, we cannot make any comments about the liquidity of the business, whether it carries too much or too little working capital. Qazi Ashfaq | Financial Statement Analysis 10